Electronic trading is revolutionizing the futures industry. European futures trading has been fully computer-based for several years. In the U.S., many of the benchmark financial futures contracts (U.S. Treasury futures, S&P 500 and Nasdaq 100 futures) are now primarily transacted on the screen. The rapid growth of electronic trading is further illustrated by the fact that the German-Swiss Exchange (EUREX) founded in 1990 has surpassed the CBOT as the leader in futures trading.
There are, however, substantial limitations of current electronic trading systems when applied to institutional options and futures spread trading. Designed more than a decade ago, electronic futures trading platforms are based on rigid, outdated architecture. All message traffic passes through centralized Exchange servers. Communication is ‘one-to-all’ and ‘all-to-one’, i.e. every price update triggers thousands of messages. Users are unable to flexibly query the market for indicative quotes for ‘wholesale’ orders or customized spread combinations. While the existing trading platform architecture works for futures trading with a single price point, it fails completely in markets that are ‘relational’, i.e. every price is linked to other—or hundreds of other—prices. This problem is illustrated by the relationship of E-futures, E-options and E-spreads.
Outright E-futures have a single price point. As the futures price changes, traders cancel, modify and replace single orders. This is illustrated in Table I.
TABLE I30-Year Bond Futures BookContract - December 2000BIDSASKSQuantityPricePriceQuantity35098.2198.2222025098.2098.2315030098.1998.25400
Options involve puts and calls and combinations of puts and calls and/or futures, as well as straddles, strangles, butterflies, strips, etc. all of which result in thousands of price points being linked to each future. Thus, as the underlying futures price moves, thousands of price updates are needed. This is illustrated in Table II.
TABLE II30-Year Bond Options BookContract - December 2000BIDSASKSInstrumentStrikeQuantityPricePriceQuantityCall9800200130136100Call9900150556350Put9800504752250Put97001752831300Straddle9600-10002005558150Call Spread9800-1000250252650
There are few ‘real’ prices displayed for options and spreads on electronic screens because market makers cannot make tight markets across numerous price points. As the futures price moves, ‘stale’ options and spread prices remain exposed to the market.
Current electronic options and spread markets have significant disadvantages. In the United States, despite the rapid growth of electronic futures, there is no real volume in electronic options, options spreads and complex futures spreads. These markets still trade on the floor. In Europe, where futures markets are 100% electronic, price discovery in options, options spreads and complex futures spreads takes place manually in an informal “upstairs” or “cash” phone-brokered market. The European ‘phone-brokered market’ is widely disliked by all participants except the brokers who charge commissions to both sides of a trade. European options screens do not show ‘real’ prices. End users complain of the lack of transparency (only the brokers know the real bids and offers) and the inability of end users to verify that orders have received ‘best execution’ treatment. Users and market makers also do not like the high cost of this brokerage and brokerage costs for market makers are passed on to users in the form of wider bid-ask spreads. Exchanges, regulators and end users are concerned by the counterparty risk inherent to the system: market integrity rests on the performance guarantees of unregulated, thinly capitalized brokers.
The regulatory concerns surrounding the practices of the European, phone-brokered options and spread markets are so severe that this issue has become a focal point in the CFTC's and U.S. Congress' review of the application by Eurex to start a U.S. futures exchange in the Spring of 2004. Major market participants have provided testimony to Congress describing the lack of market integrity in the phone-brokered, “payment-for-order” flow model that exists today on European exchanges. There is substantial concern that the phone-brokered options and spread trades violate ERISA obligations requiring competitive execution of pension fund and other institutional customer derivatives orders.
U.S. Pat. No. 6,016,483 describes a computer-based system for determining a set of opening prices for options traded on an options exchange and for allocating public order imbalances at the opening of trade. This patent is incorporated by reference in its entirety.